Beware of market forecasting silly season

RobertSeawright

Economic and market forecasting is really hard. There are simply too many variables and too much uncertainty (Donald Rumsfeld's infamous but accurate "unknown unknowns" comes to mind) for forecasting to be anything like easy.

Indeed, as Yoram Bauman, the Stand-Up Economist humorously points out, economists have correctly forecast nine out of the past five recessions.

That's why the results of an interesting CXO study should not be surprising. Since 1990, the Federal Reserve Bank of Philadelphia has conducted a quarterly Survey of Professional Forecasters, continuing research conducted from 1968-1989 by the American Statistical Association and the National Bureau of Economic Research. The survey asks various economic experts their views of the probabilities of recession for each of the following four quarters and comes up with an "Anxious Index" reflecting those asserted probabilities.

The CXO study determined that the forecasted probability of recession for a quarter explained absolutely none of the stock market's returns for that quarter. In fact, the data suggest that the forecasts were a mildly (if not materially) contrarian indicator of future U.S. stock market behavior. The survey reads like a primer on recency bias in that bear markets lead to bearish market forecasts and vice versa while the forecasts have no predictive power whatsoever.

Based upon the historical record, it's even a bit surprising that forecasts are attempted at all.

No less an authority than Milton Friedman called Irving Fisher "the greatest economist the United States has ever produced." However, in 1929 (just three days before the notorious Wall Street crash) Fisher all but destroyed his credibility for good by forecasting that "stocks have reached what looks like a permanently high plateau."

Those of you who were around for the tech boom just prior to the turn of the century may remember a book published in late 2000 by James Glassman and Kevin Hassett entitled “Dow 36,000.” Its introduction states as follows. "If you are worried about missing the market's big move upward, you will discover that it is not too late. Stocks are now in the midst of a one-time-only rise to much higher ground — to the neighborhood of 36,000 on the Dow Jones Industrial Average."

Sadly, it didn't exactly work out that way and a used paperback copy of the book may now be purchased online for as little as a penny. It isn't even worth that much except perhaps as a reminder of the perils of forecasting.

Somewhere around that same time I remember seeing a CNBC interview with a geriatric equities manager who claimed that the "old rules" of investing and risk management no longer applied. In his view, so much money was flowing into the markets via 401(k) investments and the like and the ("new"!) economy had so fundamentally changed the investment universe that a 100% tech stock allocation was perfectly safe even at his advanced age.

We all know how that forecast turned out.

More specific market predictions do not generally fare any better. Back in 2000, Fortune magazine picked a group of ten stocks designed to last the then-forthcoming decade and promoted them as a "buy and forget" portfolio of their best ideas. Unfortunately, one who purchased that portfolio would want to forget it. If one had invested $100 in an equally weighted portfolio of these stocks back then, 10 years later there would have been only $30 left.

Of course, there are many similar, even worse examples. In December of 2005, Fortune (again!) was pitching "10 sturdy stocks" that it claimed were "built to last." Citigroup
C, -0.71%
at $50 and Washington Mutual at $42 featured prominently. Within two years, both of these stocks were well on their way to zero.

We are now head-long into what my friend Josh Brown calls the "silly season of forecasts." Individuals and firms are talking about how they expect the economy and the markets to perform in 2013. Those outlooks can be helpful exercises and provide excellent food for thought. They can also be fun and entertaining.

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